Monthly Archives: May 2016

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By a vote of 56 to 41, the Senate passed a resolution of disapproval (H.J. Res. 88) to prevent the Department of Labor’s implementation of the final rule, “Definition of the Term ‘Fiduciary’; Conflict of Interest Rule – Retirement Investment Advice.” The U.S. House of Representatives voted to pass the rule on April 28, 2016, which now awaits President Obama’s signature.

Lofchie Comment: The President will most likely veto this bill. It is unlikely lawmakers will have the votes to override the veto. Certainly, the Department of Labor had the legal authority to adopt the rule (subject to any potential procedural change). It should go forward as adopted, notwithstanding (i) serious policy objections to the rule and (ii) the fact that a Congressional majority considers it to be flawed. That said, this “victory” of rulemaking exemplifies the wrong way to conduct regulatory policy.

In practice, the DOL’s fiduciary rule covers a lot of ground. If the DOL had adopted a less burdensome rule, then a majority of Congress might have considered it to be workable. In an even better scenario, the DOL might have agreed to collaborate with the SEC on a rule that would be applicable to all retail investors (which could have been the most rational solution of all from a policy perspective). Proponents of the DOL rule would have viewed such compromise as flawed. Nevertheless, any such compromise would represent a better way to conduct regulatory policy; i.e., it would reflect an attempt to achieve a consensus.

Director of the Office of Financial Research Richard Berner discussed the ways in which credit risk affects the stability of the financial system. At a conference at New York University, he touched on current OFR measures for monitoring credit and other risks, examined the interplay between credit and other kinds of risk, and assessed some of the tools that policymakers might use to mitigate those risks.

Mr. Berner asserted that in order to improve the measuring, assessing and monitoring of risk, the quality, scope and accessibility of financial data must be enhanced. Although progress has been made, he said, risks and vulnerabilities that are “neither immediately evident nor easily monitored” remain.

Mr. Berner cautioned that periods of low volatility, credit spreads in cash markets, credit default swap spreads and low repo haircuts – all of which are interpreted traditionally to be signs of low financial market risk – can presage rising market vulnerabilities, since they offer incentives to investors and risk managers to increase leverage. He explained that the implications of this paradox suggest that the distribution of outcomes is asymmetrical, which means that the pricing of all securities with embedded options will be affected by volatility. This inherent asymmetry has an important effect on credit risks, since lending involves selling puts on the probability of default.

Mr. Berner concluded that in order to monitor activity across the financial system, the OFR must continue to improve the “toolkit” that it uses to assess the fundamental sources of instability in the financial system. It also must become more forward-looking and test the system’s resilience to a wide range of events and incentives. He maintained that stress testing “is one of the best tools for assessing potential sources of vulnerabilities,” but added that more granular data are needed to determine who is exposed to those vulnerabilities and by how much.

Lofchie Comment: One of the best books ever written about financial crises is Stabilizing an Unstable Economy, by Hyman Minsky (1986). The book enjoyed a resurgence of popularity in 2010 with a number of articles dating from that period maintaining that we were in a “Minsky Moment” (of the type predicted in the book). A number of Mr. Berner’s conclusions seem to echo Mr. Minsky’s theories, particularly the view that periods of low volatility can seduce investors into taking on too much leverage or other kinds of risk.

SEC Chief of Staff Andrew J. Donohue shared professional insights he acquired during his forty years of experience in legal and corporate compliance. Mr. Donohue emphasized the following ways to help maintain effective corporate compliance programs:

utilize people of integrity who accept personal responsibility for corporate compliance programs;

maintain a culture dedicated to “always doing the right thing” and “not tolerating bad practices or bad actors”;

ensure the correlation between ethical behavior and reward structures within the firm;

simplify policies and procedures by making them as clearly applicable and intuitive as possible;

harness technology in order to ensure compliance, but maintain personal responsibility for any errors that may occur;

identify the blind spots that can occur in compliance programs when firms implement increasingly complex operations, products and services; and

continually ask what compliance programs and officers might be missing.

Mr. Donohue delivered his remarks in a speech at the Rutgers Law School Center for Corporate Law and Governance.

SEC Chair Mary Jo White outlined new agency initiatives in investment company regulation. She delivered her remarks before the 2016 General Membership of the Investment Company Institute.

As to contemporary asset management initiatives, Chair White identified the following as the most significant areas for regulation: conflicts of interest, registration, reporting and disclosure, portfolio composition and operational risks. Chair White highlighted the recent rulemakings on liquidity and derivatives as examples of the SEC’s new focus.

Chair White stated that the Division of Investment Management is reviewing fund disclosure effectiveness, and the SEC staff is undertaking further review of exchange-traded funds. While emphasizing technology risks, the use of service providers and the importance of accurate portfolio pricing, Chair White encouraged funds to focus on valuation, performance advertising and issues that may arise when funds make payments to intermediaries for the distribution of fund shares.

Lofchie Comment: The SEC’s proposals regarding liquidity and derivatives have been subject to significant negative reaction. The common theme from both industry and academic critics is that these proposals are economically simplistic and only appear to reduce risk. This may work for the economically unsophisticated (e.g., those who believe that all derivatives are inherently risk-creating), but in reality, those fearful of derivatives would increase risk by discouraging the use of hedging techniques that employ derivatives.

Chair White acknowledged that the SEC received critical feedback on both proposals. Regarding the derivatives proposal, she stated: “many commenters, however, are not in favor of the proposal’s portfolio limitations and some have provided a range of suggested modifications and alternatives.” Concerning the liquidity proposal, she noted: “many [commenters] expressed concerns about the liquidity classification framework and operational challenges for swing pricing.” It remains to be seen how, or even whether, the SEC will respond to these important criticisms.

The Office of the Comptroller of the Currency (“OCC”) provided guidance to national banks and federal savings associations on the 2014 SEC revised money market fund (“MMF”) rules. The guidance (i) describes how the SEC’s MMF rules will likely affect banks, (ii) addresses product and process changes that affected banks should consider, and (iii) highlights potential compliance, liquidity, operational and strategic risks. The guidance emphasized that while the SEC’s MMF rules do not directly apply to banks, they do have many implications for the way banks conduct their business. For example, some banks will now need to be able to report and process transactions to four decimal places due to the possibility that an MMF’s NAV will float.

Lofchie Comment: Just like banks, broker-dealers should also review their treatment of MMFs that have a floating share value or that otherwise do not behave in the same manner as “traditional” MMFs. For example, one question that firms must consider is whether or not a share in a floating value MMF should be treated as a cash-equivalent for margin purposes.

The Bank of England has just posted weekly historical data of its balance sheet from 1844-2006. The Bank Act of 1844 required the Bank to post a weekly statement, known as the Bank Return. The requirement began a new era in financial transparency — one that is still not yet fully achieved in many countries. The Bank Act had an influence on many subsequent central banks, within and outside of the British Empire. Many of them were organized in imitation of it and likewise required to issue a weekly financial statement.

The Bank Return is also important in itself. The Bank of England was in the 19th century and in the early 20th century the world’s most important financial institution because of the pound sterling’s role as the world’s reserve currency. Even after the pound ceded that role to the dollar, London remained the world’s biggest financial center. The high-frequency information that weekly data provide are especially useful for analyzing periods of financial panic. (There are also less complete daily data, not yet digitized, that offer even more detail.)

The data were digitized by Huaxiang Huang and Ryland Thomas. Thomas, who kindly informed me of the availability of the Bank Return, is also involved in a project to make other key long-term British historical data readily available: “Three centuries of macroeconomic data,” a revision to which is forthcoming.

Historical Financial Statistics has incorporated some of the data from “Three centuries of macroeconomic data.” Sometime in the summer, Historical Financial Statistics will release a series of spreadsheets showing weekly, monthly, or annual data for a number of central banks, in their original format (copyright permitting) and in a standardized format to permit cross-country comparisons. Among the data that will be included are weekly statements of the Bank of England, Bank of France, Reichsbank (pre-World War II German central bank), Indian Paper Currency Department and the Reserve Bank of India, and Federal Reserve System. Data on a number of other monetary authorities, including the Bank of Japan, Norges Bank, and possibly the State Bank of Russia, will be available at monthly frequency.

The U.S. Department of the Treasury (“Treasury”) and the SEC announced a joint collaboration to build an efficient and effective structure that will track transactions in the Treasury cash market. As part of this effort, the agencies “requested that [FINRA] consider a proposal” to require member firms to report Treasury cash market transactions to a centralized repository.

Treasury asserted that public responses to previous requests for information on the most effective means for obtaining official sector access to cash market data demonstrated “broad support” for more comprehensive reporting to regulators.

Lofchie Comment: Assuming that FINRA “considers a proposal,” one wonders whether the Treasury and SEC will be able to make use of the information collected. After all, it is increasingly evident that part of the reason for increased volatility in the market is not the result of “bad” behavior, but rather from diminished liquidity resulting in part from increased regulatory and capital costs. Anyone attempting to argue that the costs exceed the benefits of such a central information collecting scheme should understand the intellectual bias at the regulatory agencies against concluding that increased regulation may have negative results.

Today we release CFS monetary and financial measures for April 2016. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.9% in April 2016 on a year-over-year basis versus 4.6% in March.

The SEC awarded more than $3.5 million to a company employee whose “tip bolstered an ongoing investigation with additional evidence of wrongdoing that strengthened the SEC’s case.” The Order stated that “the Claimant’s information caused Enforcement staff to focus on [redacted] when staff might otherwise not have done so, and this evidentiary development strengthened the Commission’s case by meaningfully increasing Enforcement staff’s leverage during the settlement negotiations. As such, Claimant’s information significantly contributed to the successful enforcement of the Covered Action within the meaning of Rule 21F-4(c)(2).”

Lofchie Comment: This case may be the first in which a whistleblower award was granted to an employee who did not produce evidence that initiated a case, but rather evidence that furthered an ongoing investigation of which the employee was aware. For those who find the concept of whistleblower payments troubling, at least in the case of whistleblowers who do not first raise the issue within their own organization, this case should raise the level of discomfort. In effect, the SEC offers a bounty to employees to provide unfavorable information about their employer without resolving the matter internally.

To even the playing field, perhaps private litigants should be able to offer payoffs to government employees who come forward with evidence pointing to weaknesses in the government’s evidence. Why should government activities be conducted without the guards against improper behavior that apply to private activities?

design a template in order to establish the standard for developing data collection,

develop clear and precise definitions, and

create specifications for the data collection process.

Lofchie Comment: Here are a few more recommendations to add to the OFR’s list: (i) consider the costs of collecting the information, (ii) determine whether the means of requesting information are standardized adequately to yield comparable data from different sources, (iii) determine whether the means of transmitting the information actually exist, (iv) ascertain whether there is a way to store the information, (v) confirm that a method is in place for assessing the success or failure of the information program (and whether it should be modified or abandoned), and (vi) consider whether the information already may be available from other sources, such as from other agencies. In other words, consider the practicalities when seeking to collect data. As an example of what not to do, please review the experience of Form PF.